08.23.2023 The S&P 500’s strong performance this year has been powered by the promise of artificial intelligence (AI). Investors’ optimism for the “future is now” technology has been manifested by its outsized impact on a handful of the largest names in the S&P. Chatter about, and media coverage of, AI kindled investor enthusiasm and mega-cap buying interest. The AI thesis will be tested on Wednesday afternoon with chipmaker NVIDIA’s earnings disclosure. If AI disappoints and the market deflates, what theme or group of stocks stands a chance of outperforming the broader market?
Investor sentiment is a useful contrarian indicator, at least at emotional extremes, and emotions are running high this year. That’s because pessimistic investors have low expectations and in a market that is, at least over the near term, fueled by the intersection of reality and expectations, it’s better for investors to have low expectations rather than high expectations. Whether driven by a hunger for AI, or simply by free-floating optimism or fear, investor sentiment has been driving the market’s direction in recent months. Pessimism was pervasive at the outset of the year as investors grappled with escalating inflation and the Fed’s single-minded mission to quell rising prices at virtually any cost. History has shown that markets built on bearish foundations tend to outperform markets awash in optimism. By the end of July, bullishness surged once the S&P 500 crossed the 20 per cent mark. The market reversed as disappointment set in, falling about five per cent from its mid-year peak. Now, investor enthusiasm has pulled back to neutral.
By the middle of the year, the capitalization-weighted S&P 500, fueled by a handful of stocks, outpaced the equal-weighted S&P 500 by nearly 10 percentage points, a feat last seen amid the pandemic lockdown in 2020. This left the S&P overvalued by traditional measures, like its price/earnings (P/E) multiple. However, if we take away the handful of mega-cap AI beneficiaries the average stock in the market is fairly priced. The 10-year, BBB corporate bond yield is a useful gauge. The reciprocal of today’s yield of 5.96 per cent implies a forward P/E of 17x. Today’s forward P/E is nearly 20x, although the average stock in the Index sports a more favorable forward P/E of 17x.
High-yielding dividend stocks have been among the worst performers this year, as investors swapped bond substitutes for actual bonds as yields became competitive. High-dividend stocks offer generous yields for a variety of reasons, not all of which are compelling. Stocks with dividend yields that are generous relative to their share prices are often candidates for dividend cuts, especially if the outsized yield was the result of a share price decline rather than dividend increases.
Dividend growers, on the other hand, have a track record of maintaining and growing their dividends over time. They tend to be high-quality companies with strong balance sheets. Sector-wise, dividend growers underrepresent technology, since many fast-growing companies don’t offer dividends (although tech behomoths Apple and Microsoft are dividend growers). Nonetheless, dividend growers have outperformed the S&P 500 over the long term, as these quality companies possess staying power. Since 1992, dividend growers, as represented by the S&P Dividend Aristocrats Index, have outpaced the S&P 500 by about 840 percentage points. With the exception of trailing the S&P 500 over the three years culminating in the tech bubble of 2000, the S&P Dividend Aristocrats Index has performed admirably against the blue chip index over rolling three-year periods as well.
Dividend growers, whether due to the quality of the underlying companies or their consistent dividend payouts, have exhibited less downside than the S&P 500 in periods of market stress. During the bear market of 2001-02, the S&P declined more than 47 per cent from its 2000 peak, while the S&P Dividend Aristocrats Index lost about 25 per cent. At the bottom of the 2008 financial crisis, the S&P 500 lost more than 55 per cent peak to trough, while the dividend growers declined about 48 per cent. During the most recent selloff in 2022, the S&P pulled back about 25 per cent before recovering, while the dividend strategy shed about 18 per cent at its lowest point last year. History has shown that dividend growers have about 88 per cent of the downside risk of the S&P 500, thanks to their financial consistency.
Bottom Line: We believe an allocation to high-quality dividend growers in today’s market makes sense given their relative valuation and quality. Moreover, dividend payouts have grown much faster than the inflation rate over time, making them a valuable feature in an environment of rising prices.